As an investor you’ve most likely heard about the tradeoff between risk and return, the idea you must take more risk to receive higher returns. While this is true, most investors don’t know how to construct an efficient portfolio and therefore it’s likely they are taking more risk than necessary for less rewards. In these cases it is usually possible to reconstruct their portfolios to achieve higher returns with lower risk.
With that in mind, let’s go over some of the key features of an efficient portfolio.
Investors come in many stripes. Some value safety above all and others can tolerate higher levels of risk. Investors are individuals with different tolerances for risk. When constructing your portfolio it is essential you construct it in accordance with your risk tolerance.
To determine your tolerance, the Pragmatic Investor defines 10 risk tolerance groups – group 1 indicating a very low tolerance for risk while group 10 indicates a much higher risk tolerance.
The Pragmatic Investor asks you a series of questions and, based on your answers, assigns you to one of the 10 groups. Then it uses this group any time it needs to make decisions about your portfolio – from initial creation, selecting which stocks to recommend you hold, how you diversify and allocate and even how you rebalance.
By tailoring its recommendations to your specific risk tolerance level, the Pragmatic Investor takes your circumstances into consideration. It develops a clear understanding of your risk preferences in order to construct and manage the best portfolio for you given your risk comfort level.
Investing is a balancing act, always trying to determine the correct balance between returns and risk. Of course you can always go back and adjust your risk tolerance if something in your life changes.
Typically younger investors can hold riskier portfolios because they have more time to recover or adjust if something goes wrong. Older investors usually play it safer unless they have substantial assets in other areas – such as real estate holdings or other non-stock-market investments. But that’s just a rule of thumb. Specific circumstances may come into play regardless of an investor’s age so that’s why the Pragmatic Investor determines your risk profile.
Keep in mind that the Pragmatic Investor was designed for long term investing. If you know you will need your money in less than 5 years, you should not put it in the stock market but use other, less volatile instruments.
One of the benefits of Value Investing is the fact a carefully selected Value-based portfolio can reduce risk while positioning your portfolio to achieve greater returns. This is possible because Value Investing analyzes a company to determine its strength based on management, profitability, history of earnings and many other items. It also looks at the risk of competition and future viability by using what Warren Buffett calls a company’s, “moat strength.” It then only recommends investing in companies that rate highly in these areas.
Further, it recommends investing in these strong companies only when they are undervalued. Value Investing methods calculate what a company’s value should be and recommends investing when you can purchase shares below the company’s value. This is what Benjamin Graham and Warren Buffett refer to as the, “Margin of Safety.”
By doing just these two things Value Investing significantly reduces risk. Strong companies are inherently less risky than weak ones. When you purchase strong companies at less than what they’re worth you reduce risk further while at the same time positioning yourself to make a profit even if the company just gets back to its true value.
So before you even look into the traditional risk management techniques, you’ve already positioned yourself to potentially reduce risk and increase returns.
In addition, the Pragmatic Investor constantly monitors the stocks you hold and alerts you to any change in their quality or value. If a previously highly rated stock becomes less so, or if its price rises so it’s now overpriced, you’ll automatically be alerted.
The next step is to diversify. You might recall being told that diversifying over a number of stocks is a smart action to take.
However you might not know why. In a nutshell it goes back to something Harry Markowitz discovered in the 1950s. He knew the total return provided by a portfolio is simply the weighted average of the individual returns of each component in that portfolio.
So, if you invest 20% in Stock A, 40% in Stock B, 30% in stock C and 10% in stock D, then your total return comes 20% from Stock A, 40% from Stock B, 30% from stock C and 10% from Stock D.
If Stock C performs better than the others you could increase your total return by investing more in Stock C. This was well known before Markowitz’s work.
Markowitz’s big contribution, however, was to show that risk does not work the same way as returns. Rather, risk is a combination of each component’s individual risk AND it is also a function of the correlation between each component.
Correlation is a mathematical term that describes how assets move relative to one another. Highly correlated assets tend to behave the same way over time. When one goes up, so does the other. When one goes down, the other does too.
Assets with negative correlations move in opposite directions. When one is up, the other is down and vice versa.
Assets with no correlation move independently of one another. Given the movement of one, you don’t know what the other will do.
It turns out this behavior is a major key to reducing risk because if you select low or negatively correlated stocks then they tend to counteract each other – so when some are down, others are up. This can reduce the variability in their combined returns – and since variability is the standard way to measure risk, it therefore reduces a portfolio’s overall risk.
And that’s why diversification is important. By constructing your portfolio to contain several stocks with low correlations between them, you can lower your risk exposure. The important point to remember is just holding a large number of stocks does not mean you are properly diversified. The stocks in your portfolio must have low correlations between them.
Another method to achieve better returns and manage risk is to intelligently allocate funds between the diversified stocks in your portfolio. Many investor simply throw an equal amount of money into each investment. While this can work, most times it is better to allocate funds based on an individual stock’s return and risk characteristics.
This really comes into its own when rebalancing back to your initial portfolio allocations over time and can further serve to increase your returns and reduce your risk by forcing you to buy low and sell high in a far more effective manner.
Perhaps the most underused or, more likely, never used method of risk reduction is rebalancing. Many investors create an initial portfolio and then leave it alone – never looking at it until they need money for something. This is the classic buy and hold strategy. Unfortunately it’s not a good strategy to follow.
The reason? Over time stocks behave differently. Their prices move up and down, usually at different rates and at different times. If you don’t look at what’s happening, eventually the better performing stocks will come to dominate your portfolio. This can substantially increase your portfolio’s risk by causing you to become less diversified.
As an example, suppose you started with two stocks and invested 50% of your money in each one.
Over time, say, Stock A increases in price while Stock B decreases in such a way that the result is Stock A now comprises 90% of your portfolio while Stock B accounts for only 10%. You’re now severely overweight in Stock A. If something disastrous were to occur with Stock A, your portfolio could be affected more severely than it otherwise would have to be.
However when you constantly rebalance you force yourself to sell some shares when a stock rises, thus locking in your gains, and purchase shares of a stock that doesn’t rise as fast or falls. In essence you buy low (when shares are down) and sell high (when shares are up).
Doing this continually can greatly increase your returns and lower your risk because stock prices don’t rise, or fall, forever. So if you chose high quality stocks you can reasonably expect the ones that rise to fall back to some mean value and the ones that fall to rise again.
By rebalancing when necessary you take advantage of the different price movements to increase your returns and ensure your portfolio stays allocated in an efficient manner – thus reducing risk.
The Pragmatic Investor continually watches your portfolio for rebalancing opportunities. It constantly monitors what’s occurring and automatically recommends adjustments so your allocations stay effective, you lock in gains and buy low and sell high.
As you can see, it takes a lot of effort to properly manage your investments and that’s where the Pragmatic Investor shines. It automates all the important pieces and is constantly monitoring your portfolio to ensure it’s effectively working for you at all times.